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Certainty Equivalent Expression
Posted: September 15th, 2003, 1:30 am
by Tait5
HiI have been given the following Certainty Equivalent Expression to solve for a credit spread given the risk neutral probability of default. My problem is the 'n' term in the denominator on both sides. If n is the number of years to maturity, as n gets larger, the credit spread figure that solves the equation gets smaller. This does not sqaure with the real world where corporate bonds generally exhibit larger spreads the longer the term to maturity.Can anyone help ?Thanks.
Certainty Equivalent Expression
Posted: September 15th, 2003, 3:11 am
by weare
The fundamental certainty equivalent expression for credit spread is1/(1+rf+CS) = (PD*R + 1-PD)/(1+rf) 1-year case1/(1+rf+CS)^n = (PD*R + 1-PD)/(1+rf)^n n-year casewhere rf: riskfree rate, CS: credit spread, PD: default probability, R: recovery rateBy some manipulation gives,CS = (1+rf)(E^-(1/n)-1) where E=(PD*R + 1-PD)If one considers the PD and the R as constants, then CS declines by n.But as time increases, the default probability also increases....I guess you missed this point........weare
Certainty Equivalent Expression
Posted: September 15th, 2003, 3:32 am
by Tait5
Thanks
Certainty Equivalent Expression
Posted: September 15th, 2003, 5:24 am
by Tait5
HiI really can't get this result. For me the equation says the spread increases as n decreases irrespective of PD and R being constantHelp please ?1/(1+Rf+CS)^n = (PD*Recovery+1-PD)/(1+Rf)^nCS = spreadRf = risk freeRecoveryn = maturity
Certainty Equivalent Expression
Posted: September 17th, 2003, 4:24 am
by Tait5
Finally got it ! My only excuse is that I've been tired lately.It seems to me that the compensation in terms of spread as you go out along the curve for a particular bond is very generous given the increase in the probability of default, which is relatively marginal.Any thoughts ?